Relationship between risk and return

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By now you should understand that even with the most conservative
investments you face some element of risk. However, not
investing your money is also risky. For example, putting your
money under the mattress invites the risk of theft and the loss
in purchasing power if prices of goods and services rise in the
economy. When you recognize the different levels of risk for each
type of investment asset, you can better manage the total risk in
your investment portfolio.

A direct correlation exists between risk and return and is
illustrated in Figure 4–2. The greater the risk, the greater is the
potential return. However, investing in securities with the greatest
return and, therefore, the greatest risk can lead to financial ruin if
everything does not go according to plan.

Figure 4-2 Risk and Return

Understanding the risks pertaining to the different investments
is of little consequence unless you’re aware of your attitude toward
risk. How much risk you can tolerate depends on many factors, such
as the type of person you are, your investment objectives, the dollar
amount of your total assets, the size of your portfolio, and the time
horizon for your investments.

How nervous are you about your investments? Will you check
the prices of your stocks daily? Can you sleep at night if your
stocks decline in price below their acquisition prices? Will you call
your broker every time a stock falls by a point or two? If so, you do
not tolerate risk well, and your portfolio should be geared toward
conservative investments that generate income through capital
preservation. The percentage of your portfolio allocated to stocks
may be low to zero depending on your comfort zone. If you are
not bothered when your stocks decline in price because with a long
holding period you can wait out the decline, your portfolio of
investments can be designed with a higher percentage of stocks.
Figure 4–3 illustrates the continuum of risk tolerance.

A wide range of returns is associated with each type of security.
For example, the many types of common stocks, such as
blue-chip stocks, growth stocks, income stocks, and speculative
stocks, react differently. Income stocks generally are lower risk and
offer returns mainly in the form of dividends, whereas growth
stocks are riskier and usually offer higher returns in the form
of capital gains. Similarly, a broad range of risks and returns can
be found for the different types of bonds. You should be aware of
this broad range of risks and returns for the different types of
securities so that you can find an acceptable level of risk for
yourself.